KBHome returning to its roots

There's a very interesting (and lengthy) story in the current issue of Fortune magazine (and available at CNNMoney.com) about homebuilder KBHome and how it, like other builders, rode the wave of the housing bubble by building increasingly pricey homes. In the process, however, it moved away from its core product, namely entry-level and first-time-move-up homes that were affordable enough to often compete with the rental housing stock. There are also a lot of swipes at former CEO Bruce Karatz, so it'll be interesting to hear what former KB alum have to say about this article:

During the bubble, KB Home (KBH, Fortune 500), like many other big builders, blew up its old-line business by going ritzy and building expensive houses. Now KB is among the first homebuilders to recognize the error of its ways, and it is returning to its roots as a purveyor of low-cost, smaller homes. In some cases KB is even using the same façades from the go-go years and then shrinking the house that lurks behind them to be half as deep - and about half as expensive. "If I had to write a headline for housing, it would be back to basics," says Broad. "The right thing to do is just what KB is doing: build starter homes that compete with rentals."

KB's recovery plan is not just a tale of two houses. It is a tale of two CEOs. During the bubble Bruce Karatz, a flamboyant marketer, believed that the public's hunger for McMansions would keep the good times rolling for years to come. It was his successor, Jeff Mezger, a hammer-and-studs operator, who recognized that the world had gone mad and steered KB back to first-time buyers. That strategy shift may prove to be a primer on how the housing market rejuvenates itself after a boom and a bust...

In hindsight, the reason for the current malaise is simple: too few buyers. By 2007 more and more people were frozen out of the market - especially the entry-level buyers, who now account for as much as 30% of new-home sales. They're the twentysomething young professionals who rent until they get married or the first child arrives, and then reach for the American dream of homeownership. From 2005 to 2006 some first-timers rushed to purchase homes they couldn't afford with the help of exotic loans. But another big group of young consumers steered clear and are finally looking to buy. Now that prices of new houses have fallen as much as 30% in areas including the Inland Empire and the outskirts of Phoenix, they are returning- prompting a turning point in the housing cycle. Call it the New Affordability...

Today seven in ten KB customers are getting financing from the FHA. The current rates are below 6%, more than 100 basis points under those on jumbo mortgages not backed by the FHA or Fannie Mae or Freddie Mac. (Fannie and Freddie lend less readily to people with past credit problems and hence aren't as crucial to the entry-level market as FHA financing.) Congress has raised the FHA limit to $729,750 in high-cost areas like Los Angeles through the end of 2008. But even if the limits aren't extended, virtually all the houses KB sells are priced for an FHA loan...

Bargain-hunters are drawn to these small houses, which look just like the behemoths built in 2005 and 2006. In Beaumont, a community of tract homes 70 miles east of Los Angeles, the Seneca Springs community is dotted with 4,000-square-foot, seven-bedroom Mediterranean homes that KB built at the peak. But right next to them the company is erecting new houses with exactly the same 50-foot façades- and a big difference you don't notice from the street: They're about half as deep and roughly 2,000 square feet. Those homes preserve the community's curb appeal by keeping the façades looking similar and sumptuous...

During the bubble KB lost its way. Building big, pricey homes wasn't a mistake- that's what the public wanted. The real problem was that management misread the future: It bought the illusion that the frenzy would last, and gorged on overpriced land. Management's grandiose thinking also pushed KB into splashy new businesses far from its traditions...

Market forces were partly to blame for KB's detour in 2005 and 2006. Builders could sell all the $400,000 homes they wanted, and the margins on those McMansions were a lot fatter than on small houses, chiefly because they could build them on virtually the same small lots as the old-fashioned starter houses. Still, some of the blame for KB's losing its way belongs to the CEO who succeeded Broad, his protégé Bruce Karatz...

In November 2006, KB also promoted its longtime COO, Jeff Mezger, to CEO. In contrast to the flashy Karatz, Mezger is a brick-and-mortar operator...It was Mezger who shifted KB's focus back to the customer who built the franchise, the first-time homebuyer. His coup was making the turn to affordability before such competitors as Centex (CTX, Fortune 500) and Ryland Homes (RYL). "By late 2005 we could see credit was tightening and investors were no longer buying," says Mezger. So he pitched his strategy toward producing the old KB product. "We needed to build houses priced for the median incomes of our communities," says Mezger. "We got away from that in 2004 to 2006." He also strove to build big financial reserves to provide KB with the staying power to weather the stricken market, for several years if needed. Hence, KB sold off huge landholdings and thousands of homes at a loss...

KB is booking those losses because it's been selling homes and lots at well below the amount it spent to build or buy them. But it put out that cash years ago. Now Mezger is building fewer homes and acquiring less land than in the past. So despite the accounting losses, KB is taking in far more cash than it's putting out. As a result, it has increased its cash hoard from $700 million to $1.3 billion and has reduced debt by almost $1 billion, or 33%, in the past 18 months...

Today both land and construction costs are falling rapidly. In California's Inland Empire, the price per finished lot has collapsed, plunging from $150,000 at the peak to about $50,000. Labor costs, the single biggest expense after land, are also dropping as construction trades look for work. In Florida, construction costs for a 2,000-square-foot home have dropped to $80,000, vs. $100,000 at the peak, a 20% reduction. The result is that the average sales price there has fallen from $275,000 to $215,000. In the inland areas of Southern California it has dropped from $350,000 to $260,000. Additionally, KB is cutting costs by assembling homes from prefabricated 12- and 16-foot panels that are hoisted into place with cranes. That wasn't possible when buyers coveted fancier houses with custom elements.